Pay compression: What it is and how to avoid it

If your organization has issues with employee retention, wage compression could be the culprit. This phenomenon occurs when new or less experienced employees are paid about the same as tenured employees. 

Imagine dedicating years to a company only to learn a new hire was offered the same salary as you—not a great feeling. In the United States, the National Labor Relations Act lets employees freely discuss their wages, so pay disparities are easy to expose. 

This often leads to a toxic work environment and deteriorates workplace morale. So, how do you combat wage compression? This article will explore strategies to address and prevent it.

What is salary, wage, or pay compression?

Wage compression—also known as pay compression, salary compression, or compensation compression—occurs when employees with varied skills, qualifications, and experience are paid relatively the same. This usually happens because companies offer higher starting salaries to attract new talent without adjusting existing employees’ wages. 

Wage compression can also happen when promoted employees or nonexempt workers earn more than their managers due to overtime, resulting in salary inversion. Wage compression can seriously harm employee engagement and company morale, ultimately lowering employee retention. Addressing wage compression is essential to maintaining a motivated and stable workforce with minimal turnover.

What causes wage compression?

Several factors can cause wage compression, especially in a competitive labor market. Here are some of the most common explanations for wage compression:

• Tight labor market: When demand for qualified candidates exceeds supply, employers may offer higher starting salaries to attract talent, unintentionally compressing wages for existing employees.
• Failure to adjust for market changes: Inadequate raises that do not keep pace with inflation or market rates can lead to employees making less money over time, contributing to pay compression.
• Inconsistent compensation structures: Poorly structured or broad pay scales can blur wage differences between seniority levels, leading to overlapping salaries that foment employee dissatisfaction.

Impacts of wage compression

Why do businesses try to avoid wage compression whenever possible? Here are the ways wage compression impacts businesses: 

• Reduces employee engagement: Employees who feel undervalued due to wage compression are less likely to feel engaged and motivated, which can reduce productivity and workplace morale.
• Increases turnover rates: High-performing, long-term employees may leave for better-paying opportunities, leading to increased recruitment and training costs for the business.
• May lead to legal challenges: Significant pay discrepancies can lead to discrimination claims. Even if unproven, these harm a company’s reputation and increase legal expenses.
• Decreases trust in leadership: Perceived inequities in pay can erode trust in management, causing broader issues with employee loyalty and organizational cohesion.

How to detect wage compression in your company

Wage compression can be challenging to identify, but recognizing the signs can help mitigate its impact. Here are six indicators to watch for:

1. Specific positions are harder to fill: Difficulty filling roles at historical base pay rates may indicate the need for market adjustments.
2. Similar salaries across different levels: Check for patterns wherein employees at various levels receive comparable pay.
3. Pay inconsistencies with market rates: Compare your salaries to those of similar organizations in your industry to identify discrepancies.
4. Disparate salaries for similar positions: Analyze job descriptions and salaries to ensure that similar positions are paid equitably.
5. Losing high performers: High turnover of top talent due to compensation concerns signals potential wage compression.
6. Uneven compensation reviews: Ensure consistent performance reviews and corresponding employee compensation adjustments.

By monitoring these indicators and regularly reviewing compensation data with managers, you can address wage compression and maintain a fair and competitive pay structure. Employee surveys can also provide valuable insights into whether pay compression is affecting job satisfaction.

How to prevent wage compression

The last thing a business wants is to create a sense of injustice among employees because of wage compression. Thankfully, a few strategies can help your organization avoid the negative impacts of wage compression on the workplace environment.

Define your compensation philosophy 

A compensation philosophy is a formal document that outlines a company’s belief system regarding employee pay, reward structure, and benefits. A strong compensation philosophy tells employees what to expect while promoting transparency and fairness that align pay ranges with company objectives. In turn, this lessens incidences of wage compression. 

Consider market trends

Sometimes, wage compression occurs when businesses fail to match raises for current employees to the market rate for starting salaries. Companies should regularly review their compensation structures to avoid this and remain competitive. They can conduct annual salary benchmarking against industry standards and make proactive adjustments based on market trends to ensure a competitive wage. 

Implement a flexible pay structure 

Businesses benefit from a transparent and flexible pay structure with performance-based bonuses and opportunities for professional development and career advancement. This approach can help mitigate the impact of wage compression and maintain employee satisfaction.

Incentive-based compensation

Incorporate incentive-based compensation (e.g., bonuses, profit-sharing, stock options, or sales commissions) to reward high performance and align employees’ efforts with company goals. Recognizing and rewarding contributions helps differentiate compensation and drives productivity and retention.

Consider nonmonetary compensation

Companies could consider nonmonetary benefits, which are increasingly valued in the current job market. These benefits can enhance overall job satisfaction and help retain employees when salary adjustments are unaffordable. Consider providing:

• Remote work options
• Wellness programs
• Benefits packages 
• Flexible working hours  

Design a fair and competitive structure

A fair and competitive compensation structure can attract and retain top talent. Regularly review and update your compensation model to ensure that it aligns with industry standards and economic conditions. This proactive approach helps you maintain a motivated and stable workforce and avoid the consequences of underpaying employees.

Communicate new policies 

Most companies have pay transparency whether they like it or not. Employees discuss their wages and can access salary information from various sources online. Put yourself in their shoes to understand their perception of the organization’s pay practices. Then, take measures to fix any discrepancies. Compensation communication is vital for the health of your workplace environment.  

Improve your payroll operations with Oyster 

Employers must address wage compression to maintain a motivated and engaged workforce. Transparent communication strategies help avoid misunderstandings and frustration. You can even engage employees in the process to foster a sense of fairness and loyalty.

Need help developing a compensation plan that aligns with industry standards? Oyster empowers you to pay your team compliantly and on time with unmatched 99% accuracy. Oyster’s Global Payroll simplifies everything from payroll and expenses to bonuses and raises.

About Oyster

Oyster is a global employment platform designed to enable visionary HR leaders to find, engage, pay, manage, develop, and take care of a thriving distributed workforce. Oyster lets growing companies give valued international team members the experience they deserve, without the usual headaches and expense.

Oyster enables hiring anywhere in the world—with reliable, compliant payroll, and great local benefits and perks.